Traditionally investment banking companies are judged on the basis of their price to book value ratio. Analysts compare Goldman Sachs’ (GS) 1.78 price to book value to Bear Stearns’ (BSC) 0.94 and say Bear is cheap and is a better buy. But is this the right way to compare investment banking stocks?
Let’s go back to basics and find out what exactly the price to book value ratio means. First, the basic equation:
Price/book value = total market capitalization / net tangible assets of the company
The total market capitalization is a number easily come by; it’s the number of shares multiplied by the current stock price. The net tangible assets are harder to come by. Net tangible assets are the total assets minus any intangible assets such as good will less all liabilities and less the par value of preferred stock.
Price/book value = total market capitalization / total assets - intangible assets – liabilities - preferred sharesThe intangible assets, liabilities, and par value are easy to find on the balance sheet and they are reliable.
Now comes the hard part, the one part of the equation that can no longer be counted on: the total assets. Let’s take Bear Stearns’ total assets for last quarter. It's comprised of cash and short term investments, receivables, property, and long term investments. The lion’s share is the long term investments. These are 263 billion dollars, roughly 2/3 of the total assets.
But there’s the rub. What are they? How are they valued? Until last year we might have taken them at that value. How much are CDOs that will ultimately be written down? How much are subprime? Investments that are going sour? That part of the price/book value is the elephant in the room. It is time for a new metric to value and compare investment houses because this one is worthless.
For now, the only reasonable way to compare these companies – Goldman, Bear Stearns, Lehman (LEH), Merrill Lynch (MER)—is to use the method we rank other industries. There we rely on P/E ratios, and specifically, earnings growth (or the lack of it) to decide which stock has the best prospects. I propose we do this for the investment houses. Here Goldman shines with its PE of 7.28 compared to BSC’s outsized PE of 135, MER’s N/A (no earnings), LEH’s 7.6. Investors should discard the useless price/book value ratio in favor of using the PE to benchmark these stocks.